The Tortoise, Not the Hare: U.S. Office Market Continues Slow but Steady Improvements

Its recovery may not be proceeding at a lightning-quick pace, but the U.S. office real estate market continued to show signs of noticeable improvement in the first quarter.

That was one of the observations of a panel of experts on a recent episode of the “Commercial Real Estate Show” radio program. The episode provided an enlightening look at the performance of the U.S. office sector in the first quarter. The topics my guests and I discussed included vacancy rates, investment sales, the healthiest markets and tenant concessions.

A slow decline in vacancies

The national vacancy rate for the office sector fell 10 basis points in the first quarter to 17.0 percent, said Ryan Severino, senior economist for Reis. Both asking and effective rents grew by about 0.7 percent in the first three months of the year, he added.

“We’re more the tortoise than the hare here,” Severino said. “We’re kind of slow but steady.”

The rest of 2013 will produce much of the same, Severino predicted. “I do expect to see continued improvement in the sector, but I don’t really expect to see any acceleration in that rate of improvement.”

The national vacancy rate should drop by another 20 to 30 basis points during the remainder of 2013, and net absorption for the year will total around 30 million sq. ft., Severino said. Asking and effective rents should grow by 2.5 and 3 percent this year, he added.

Cities that “are tethered either to the technology or the energy sectors,” such as San Francisco and Houston, have been the highest performing office markets in the past several years, and office properties in central business districts generally are outperforming their suburban counterparts, Severino noted.

Although the nation is producing new jobs each month, too few are office-using positions, and that dynamic is preventing the sector’s recovery from attaining a brisker pace throughout the nation, according to Severino.

“I would say this remains a very, very concentrated recovery,” Severino said. “Once you get away from a relatively small number of markets, there’s really little job growth and little net absorption to support a turnaround.”

In the next few years, metro areas characterized by “a high concentration of well-educated people and a fairly low cost of doing business” should produce a healthy pace of new jobs, said Glen Marker, a senior market advisor with PPR, a division of CoStar. He cited Atlanta, Dallas, Raleigh, Seattle, Nashville and Denver as markets that should see good job growth in the next few years.

Changing tenant demands

Tenants want smaller offices these days, and they often want the spaces they’re considering to be move-in ready, said Andrew Segal, the founder of Boxer Property, which owns office space across the country.

“We’re definitely seeing more open [floorplans],” Segal said. “There’s also a trend of adopting some of the looks from California. People are less interested in ceiling tiles and carpet and more interested in exposed ductwork and concrete floors.”

“The funny thing is it costs a lot of money to make something look cheap,” Segal said.

Office sales

As for investment opportunities, the amount of distressed properties available for relatively low prices is beginning to decline, said David Wheeler, executive vice president of acquisitions for Hartman Income REIT.

“We did see a fair amount of distressed sales over the last two to three years, but that is dwindling, slowly but surely,” Wheeler said. “We do expect that to continue to play out with the level of CMBS loans coming up for expiration over the next couple of years… It’s going to dwindle, but it will still be in the market for another couple of years.”

Also, class-B assets are slow to trade these days, according to Wheeler. “There does tend to be a buyer-seller gap in a lot of the B assets right now,” he said. “There are a number of owners that are just holding on for higher values, either not putting their properties on the market or testing the waters and pulling them back off.”

Because of their current lack of demand and performance, suburban office properties represent good investment opportunities for those brave enough to not simply run with the pack, Severino said.

When small businesses begin to hire more aggressively, “those suburban markets will eventually recover,” he said. “I would say it’s only a matter of time. It’s a very cyclical industry, and I think there are some pretty attractive opportunities out there for those of us who are willing to be a little more ambitious and to take a flyer on deals like that.”